Given the continued pressure on fees, subdued returns and high profile divestments, most hedge funds managers around the globe have been struggling to meet high investor expectations of late. It is therefore very unfortunate timing for leverage – using margin, credit lines and derivatives to boost returns – to become yet another area of heightened scrutiny.

Last month a report by the US Financial Stability Oversight Council (FSOC) devoted an eight-page section to leverage. The study formed part of the collaborative body’s renewed attempt to gauge how asset managers could threaten the financial system.

The council found that leverage in the hedge fund industry appears to be concentrated at larger funds, although it added that greater leverage “does not necessarily imply greater risk” and that many other factors needed to be considered.

“There is no statement yet that there is too much leverage in hedge funds,” says Jack Inglis, chief executive of the Alternative Investment Management Association (AIMA).

“Indeed, the UK’s FCA in its annual hedge fund report for 2015 analysed the 50+ largest firms and concluded there is no evidence of significant risk in the sector despite a 60 times leverage figure,” Inglis adds. “Here is where the problem lies – the measurement of leverage.”

“Measuring hedge fund leverage is a difficult concept,” adds Donald Steinbrugge, managing partner at AgeCroft Partners, a hedge fund consultancy. “When people mention the ‘hedge fund industry’, what’s really being referred to is a structure made up of a lot of different strategies such as CTAs, long/short and relative value. Leverage varies across all of these.”

An alternative is the commitment method, which is described as a “variation on the gross method with a twist,” by AIMA’s deputy chief executive Jiri Krol. “This provides for some netting and hedging, but not necessarily in right manner. It doesn’t give you an objective measure, rather it relies on a subjective assessment of a manager on what is allowed to be hedged or netted.”

To complicate comparison further, value at risk (VaR) is used for UCITS funds and the Basel III approach is used for banks. “There’s no adequate measure in place,” says Krol. “That’s a big deal for the investment industry, because we believe when it comes to examining systemic risk, consistency across sectors is of the utmost importance.”

paper focused solely on addressing the leverage measurement problem. One solution could be a blend of leverage numbers to get a bigger picture on what risk looks like across the sector.

Declining risk

“We were surprised to see it fall even further,” said UBS equity strategy Karen Olney. “This is significant. If it falls again it begs the question – will hedge funds be able to do much business?”

the part of prime brokers to provide advantageous access to leverage through relatively high margin interest rates are the two main factors,” he says.

Leverage used by hedge funds in the boom years produced stellar returns. However, results more recently are far from compelling. In the first quarter of 2016 the average fund declined by 0.8%. That follows a loss of 1.1% for the average fund in 2015, and a gain of just 3% in 2014. In other words, the average investor has earned a cumulative 1% in the past two-and-a-half-years.